Thoughts about the Oil Business

Cap and Dividend

by LexPosted: Sunday, 4/17/2011

Everyone who looks seriously at the energy issue recognizes that oil consumption will not decrease unless the price of oil is high enough that alternative energy sources are competitive. Whether you are worried about climate change or about America’s dependence on foreign oil, this question of price is inescapable. You can’t legislate economics away.

But allowing the oil price to float higher has serious consequences for businesses and individuals. The US economic infrastructure is very adapted to cheap oil, in the sprawl of our cities and the “just in time” scheduling of our businesses. Particularly hard-hit by price increases are the poor.

Several proposals have been made to introduce market incentives to reduce carbon pollution. “Cap and trade” is an approach to pollution control pioneered by Ronald Reagan and then George HW Bush, who directed its application to reduce the use of leaded gasoline and fluorocarbon refrigerants.

Under cap and trade, carbon permits are given out to historical polluters, who then can buy and sell them. Thus there is a strong incentive to reduce one’s own pollution since one can then sell permits at a profit (as well as an incentive to overstate one’s historical level of pollution!).

Cap and trade is attacked on these grounds: 1) it generates profits for polluters, and 2) it increases consumer prices, which is generally regressive. The first point is exactly correct – that’s the incentive without which the polluter would presumably not spend money to reduce pollution. The second point is also true, but it needs to be weighed that any pollution control action will have economic costs.

“Cap and dividend” is a relatively new and untested proposal, supported by several Democratic Senators, including Maria Cantwell of Washington state, whereby anyone who introduces carbon into the economy has to buy the right to do so, which means it is a levy on upstream producers and importers. There doesn’t appear to be any trading component, just an auction of the rights to produce. So it doesn’t really bear any resemblance to cap and trade.

Cap and dividend addresses the second objection to cap and trade by redistributing revenue from a permit auction to consumers, in the form of a dividend per person or household, thus offsetting the impact of higher prices. It addresses the first objection to cap and trade by not generating profits for polluters in the first place: they will have to spend to purchase permits, thus increasing their production costs.

These figures would be very difficult for the domestic independent oil & gas industry to handle. The NG levy is almost equal to the current price. An additional $26 cost per bbl of oil would probably put the domestic oil breakeven above $60 per bbl.

It is then possible that the Saudis or other foreign producers could use cap & dividend to harm US independent oil production, since they could bid up the auction rights to a level that would eliminate any domestic industry profits yet still be profitable for them. The domestic independents break even at around $35-40 per bbl. Assume a barrel price of $80; then a C&D auction bid of $45 per bbl would suffice to drive domestic producers into the red. This corresponds to a carbon levy of $346 per short ton. The Saudis’ lifting cost is around $10 / bbl (transport costs are relatively insignificant) so they would still be making a $25 / bbl profit or about 60% gross margin.

The Saudis drove the Soviets to their knees in the 1980s by flooding the market with cheap oil. They no longer have the production headroom to do that again, but C&D would give them a different weapon.

Of course, much of this assumes that the cost is mostly borne by the producers. To the extent that producers push the cost downstream, it will reduce demand and increase the incentives for efficient use of derived products. This is all good from a carbon reduction perspective; in other words, you want the producers to push the cost increase downstream as much as possible, so that the entire supply chain has an incentive to reduce carbon use. The dividend reduces the price signal to end users; however, there is still an incentive for individuals to conserve, since the dividend is not usage-based.

The real devil is in the details. How would a cap and dividend system actually work in the energy business? A lot of oil exploration is highly speculative: even with modern analytic tools such as 3-D seismic, wildcat success rates are none too high (10% or so). A producer would have to project not only the future price of oil or gas, but the future auction price of permits. Of course, producers already need to get permits to drill, as well as filing with state oil and gas boards to assure all mineral rights are respected.

When a well is producing, the extra cost associated with C&D can, depending on demand, be pushed downstream. However, a wildcatter would need some kind of insurance that a permit would be available at a reasonable price should the well come in. Thus there would necessarily be a market in derivatives against the permit auction price. Otherwise the volatility of the oil market would only increase dramatically. That would not be a good outcome for anyone.

This entry was posted
on Sunday, April 17th, 2011 at 1:12 pm and is filed under Taxation.
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